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America’s Energy Advantage

By Elliott H. Gue, on Jun. 14, 2014

Early 1985 and the immediate aftermath of the most recent financial crisis share a number of commonalities.

Almost 30 years ago, the US economy had just emerged from the worst economic downturn since the Great Depression, a severe recession that elevated the unemployment rate to 10.7 percent and sent the S&P 500 skidding 30 percent lower.

“After a lost decade of subpar returns, investors remained skeptical of equities and piled into gold.”

 

President Ronald Reagan remarked on the nation’s dour outlook and suggested a paradigm shift: “We in government should learn to look at our country through the eyes of the entrepreneur seeing possibilities where others see only problems.”

Over the course of its more than 230-year history, the US has experienced presidential administrations of every imaginable stripe: liberal and conservative, laissez-faire and protectionist, peaceful and belligerent. But the nation has continued to prosper regardless of the political climate.

America’s success doesn’t hinge on the actions of the president or the Congress. Much of the nation’s prosperity stems from the ingenuity, hard work and entrepreneurship of the American people.

The shale oil and gas revolution affirms that these fundamentally American qualities remain alive and well today. This sea change has revitalized American industry, enhanced our national security, added hundreds of billions of dollars to consumers’ pockets each year and set the stage for stronger economic growth.

Investors who understand the importance of this secular shift stand to make a tidy sum; those who bury their heads in the sand, listening to the nattering nabobs of negativity will miss out on one of the most important economic megatrends in a generation.

Morning-in-America

Click here to learn more about our Morning in America video series where we continue to explore the big shifts and interplay happening in the energy, automotive and manufacturing industries.

Humble Beginnings and Self-Belief

America’s push toward energy independence started in 1981, when the Texas-born son of a Greek goat herder founded an oil and gas company.

In the early 1980s, conventional wisdom held that growing energy demand and declining domestic production would force the US to rely heavily on expensive imports, leaving the economy exposed to a potential reprise of the 1970s Arab oil embargoes.

With memories of surging gasoline prices and rationing fresh in many people’s minds, fear of another oil shortage ran rampant.

But Mitchell refused to accept the conventional wisdom and thought the US could once again become energy independent.

His peers scoffed at this suggestion. The acreage where he focused much of his drilling activity near Fort Worth, Texas, was considered played out, a field destined to see declining production as wells matured. Some called the region the “wildcatter’s graveyard.”

But George Mitchell was undeterred despite years of only modest success.

At the time, most drillers and wildcatters operating in Fort Worth drilled simple, vertical wells to extract crude oil and natural gas from relatively shallow fields. Mitchell’s company sank thousand of these conventional wells in the 1960s and 1970s, rolling the proceeds into expanding his acreage position.

By the early 1980s, Mitchell tired of drilling wildcat wells with a 40 percent success rate; he sought to crack the Barnett Shale, a formation located thousands of feet deeper than the conventional wells his company had targeted.

Producers in the Fort Worth area had known for decades that the Barnett Shale contained significant volumes of crude oil and natural gas. Vertical wells targeting this play produced a rush of natural gas and natural gas liquids (NGL) before output quickly died off.

The Problem: Unlike conventional oil and gas fields, the Barnett Shale lacked sufficient permeability.

Oil and gas doesn’t occur in vast underground lakes or caves; rather, these hydrocarbons are trapped in the reservoir rock’s natural pores and fractures. In sandstone and other easy-to-produce formations, these pores interconnect, providing pathways through which the oil and gas can flow into the well.

Although the Barnett Shale’s pores contain significant volumes of natural gas and NGLs (natural gas liquids), these pores don’t interconnect, inhibiting the movement of hydrocarbons from the high-pressure reservoir rock to the low-pressure well.

“Mitchell unlocked this trapped resource base using two innovative technologies: horizontal drilling and hydraulic fracturing.”

Because the Barnett Shale ranges in thickness from 100 feet to 500 feet, drilling a vertical well only accesses NGLs and natural gas from the section that intersects the productive layer of the Barnett Shale.

By sinking a vertical shaft and then drilling horizontally into the heart of the formation’s productive horizon, the operator can extract more hydrocarbons per well. Higher production rates, in turn, translate into better wellhead economics.

Hydraulic fracturing involves pumping a mixture of water, sand and a small amount of chemicals into the shale reservoir under tremendous pressure. These high pressures crack the shale, creating pathways through which oil and gas can travel. The sand in fracturing fluid keeps these fissures open once the fracturing process is complete and the pressure is reduced. The sand literally props open the fractures created during this process–hence, the term “proppant.”

George Mitchell’s bet on the Barnett Shale wasn’t an overnight success. Between 1981 and 1998, Mitchell Energy drilled thousands of wells targeting the formation, perfecting its drilling and completion techniques.

When Mitchell Energy’s process of trial and error finally delivered some veritable gushers in 1998, many competitors dismissed these claims as a hoax. Nobody thought that the Fort Worth area, the wildcatter’s graveyard, would produce some of America’s most prolific onshore wells.

A few years later, Devon Energy Corp (NYSE: DVN) bought Mitchell Energy for $3.5 billion, making its founder, the son of an immigrant who sold stationary to pay his tuition at Texas A&M, a billionaire two times over.

George Mitchell’s Legacy: Energy Liberty

George Mitchell passed away last summer at the age of 94, but his legacy continues.

Thanks to the techniques pioneered by Mitchell Energy and perfected by a host of independent oil and gas companies, the US in 2009 overtook Russia as the world’s leading natural-gas producer and last year unseated Saudi Arabia to become the top producer of liquid hydrocarbons (oil and NGLs).

Slide 1

Source: Energy Information Administration

Surging production from the Bakken Shale in North Dakota, the Eagle Ford Shale in southern Texas and the Marcellus Shale in Appalachia has put the US on course for energy independence.

By the end of last year, the US no longer needed to import light-sweet crude oil to the refinery complex on the Gulf Coast and had cut its reliance on foreign oil to 15 percent of annual consumption from about one-third in 2005.

Baseline projections for the Energy Information Administration call for the US to import less than 5 percent of the energy consumed domestically by the end of the decade. And virtually all this foreign oil will come from neighboring Canada and Mexico; US dependence on oil produced in the Middle East continues to decline.

Slide 2

Source: Energy Information Administration

Rising domestic energy production gives the US a tremendous competitive advantage over developed economies such as Germany and Japan, as well as rapidly growing emerging markets such as China and India.

While the US marches toward energy liberty, China and India’s dependence on imported energy has increased steadily.

Slide 4

As recently as 2002, China was a net exporter of energy. Today, the world’s second-largest economy imports about 11 percent of its annual energy demand–and the Mainland’s reliance on expensive foreign energy will continue to grow.

India already imports more than 25 percent of its energy needs, a percentage that will increase because of dwindling domestic production and growing demand as the country industrializes.

Germany has subsidized alternative energy for decades, but still relies on imports to meet about 60 percent of its needs. Expect that proportion to rise sharply as the nation phases out nuclear power plants over the next decade. And German consumers already face some of the highest energy costs in the world.

“Rising US production of oil and gas means that US households and businesses enjoy some of the lowest energy prices in the world.”

 

Although a record cold snap in the US has driven the spot price of natural gas to almost $6.50 per million British thermal units (mmBtu), the average price for gas to be delivered over the next 24 months remains under $4.50 per mmBtu.

In comparison, EU natural-gas prices range between $11.00 and $12.00 per mmBtu, while the price in Japan stands at more than $15.00 per mmBtu.

Inexpensive natural gas means that the average America consumer pays about $0.12 per kilowatt-hour of electricity, compared to about US$0.36 per kilowatt-hour in Germany.

As we explain in The Empire’s New Textile Mills, electricity costs for industrial consumers in the US South are about half those in China, a differential that’s driving many Chinese and Indian manufacturers to relocate factories to North America.

Forget the Government

Although many promotional pieces in the newsletter industry focus on the approval of the Keystone XL pipeline or state-level regulation of hydraulic fracturing, the US energy renaissance has nothing to do with government and everything to do with American innovation and entrepreneurship.

That’s not to suggest that government policies don’t affect the energy industry; however, regulation is only one small piece of a big puzzle.

For example, the media loves to track the uncertain fate of TransCanada Corp’s (TSX: TRP, NYSE: TRP) controversial Keystone XL pipeline.

But regardless of whether the Obama administration approves the project, growing production from Canada’s oil sands will make its way to the US via existing pipelines and a growing fleet of railcars. And regulators continue to approve dozens of pipelines to support the US shale oil and gas boom.

What about fears that federal or state regulators will ban hydraulic fracturing because of environmental concerns?

States with limited potential for shale oil and gas may make a statement by banning this well completion technique, but those with untapped reserves will likely take a more reasonable tack.

For example, when California’s state legislature promoted a bill to ban hydraulic fracturing, Gov. Jerry Brown, a Democrat, refused to sign the legislation despite strong support from his own party.

For many cash-strapped state governments, the economic benefits and potential revenue from increased drilling and production are too much to pass up.

Morning in America: The US Manufacturing Renaissance

In 1990, The Machine That Changed the World topped the business best-sellers list. Written by James Womack, Daniel Jones and Daniel Roos, the book focused on the global automobile industry and the manufacturing and production techniques pioneered by Toyota Motor Corp (Tokyo: 7203, NYSE: TM).

The book was symptomatic of the conventional wisdom of the day: Japanese companies had built a better mousetrap, a superior mode of business organization that allowed them to produce higher-quality products at a competitive price.

Manufacturing-Renaissance

As a result, many self-styled management gurus asserted that Toyota and other Japanese companies eventually would run their less-efficient US competitors out of business.

At the time, the business community was in awe of the Japan’s economic miracle and rapid recovery from postwar devastation and defeat to become the world’s second-largest economy.

A soaring Nikkei 225 both reflected and fueled the world’s infatuation with Japan Inc.; the widely watched index climbed by almost 900 percent in US dollar terms between in the 1980s.

The onset of the 1990s marked a turning point for Japan’s economy. Bubbles in the country’s equity and real estate markets popped, sending the Nikkei 225 from a high of almost 40,000 in 1990 to a nadir of less than 7,000 in 2008.

Meanwhile, the collapse in real estate prices left Japan’s banks with piles of underperforming loans and helped to feed the persistent deflation that’s plagued the economy ever since.

In recent years, China has captured the public’s imagination, thanks to two decades of rapid growth that made the country the world’s second-largest economy.

This ascent has convinced some observers that China will soon overtake the US to become the world’s dominant superpower.

Others worry that China’s lower wages and newer infrastructure will continue to decimate America’s shrinking industrial and manufacturing base.

“Don’t believe the hype.”

 

Wages in China’s manufacturing sector have more than quadrupled since 2001, compared to a 30 percent increase in the US. Although employee compensation is still higher in the US, the cost gap continues to narrow.

When you factor in China’s higher energy costs and rapid wage inflation, manufacturers can operate more profitably on American soil.

We still believe in the long-run potential of the world’s emerging markets. But there’s a reason that foreign companies in 2012 invested almost US$80 billion in acquisitions and expansions to build their US manufacturing bases.

Manufacturing industries in 2013 accounted for 12.5 percent of US gross domestic product, climbing 150 basis points from the nadir of 11 percent hit in 2009. Investors shouldn’t dismiss this gain as negligible; this achievement marked the first time since the 1950s that the manufacturing sector’s share of the economy had grown for four consecutive years.

Slide 3

As more industries seek to take advantage of America’s energy advantage, this manufacturing renaissance should pick up steam.

Elliott H. Gue is founder and chief editor of Capitalist Times and Energy & Income Advisor.

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